Will Trouble in Europe Spill Over to the US?

The S&P500 inched up about 0.3% last week in very light trading. At the same time S&P volatility remained low—the VIX index stayed in the 12.5 to 13.0 range, a range that while not nearly as low as the one investors enjoyed for most of 2017 is a range that suggests investors are far from getting worried about equity market losses in the US.

In terms of technical analysis, the recent strength in the daily charts seems to be abating. Yes, the S&P is still in a short-term uptrend, but the upward momentum, despite last week’s rise in price, is showing signs of slowing down (for example the MACD lines are pinching together). On the weekly charts, the S&P500 has still not repaired the technical damage it incurred in the first four months of 2017. And if the short-term weakness on the daily charts turns into the start of another retreat, then this weakness on the weekly charts will only get reinforced. More importantly, it would demonstrate once again that when it comes to technical analysis, longer-term charts tend to over-rule shorter-term charts.

US macro results were mixed as usual last week. So nothing has changed in terms of the slow-paced growth of the US economy. Also, the Fed’s balance sheet shrank again, this time by less than a billion dollars, bring the total balance sheet reduction up to 123 billion dollars since quantitative tightening began in October 2017.

Finally, in Italy, recent national elections resulted in a proposed government that included several anti-euro cabinet members. The problem, as clearly signaled by pro-euro forces inside and mostly outside Italy (think European Central Bank and Germany) is that such a government would be unacceptable because if the chances of Italy pulling out of the euro were to increase, then the threat to the entire Eurozone would grow materially.

So what can the pro-euro forces do?  Simple. Punish the Italian government financially by allowing its borrowing rate to skyrocket. And skyrocket it did. In only a few days, the Italian 2 year government bond went from yielding almost NEGATIVE 0.3% to a POSITIVE 2.5%. This represents the largest move, upward, in yield for the Italian 2 year note…..ever.

Clearly, if the Italian people continue to challenge the powerful pro-euro forces in Europe, these forces are signalling that Italy will be punished, and this punishment will be especially painful because Italy has one of the highest government debt to GDP ratios in all of Europe.

Meanwhile, the effects of the heightened financial risks in Italy are most definitely spreading to the rest of Europe and into other regions including Asia and the US. This is strong evidence, that like in 2011 when the European sovereign debt crisis first exploded, the risk of financial contagion is real…..and possibly devastating in its force.

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